According to the National Foundation for Credit Counseling,
nearly two-thirds of Americans can't come up with $1,000 in cash to
handle an emergency expense. Instead, they'd be forced to borrow
money to cover that cost, often at the extremely high interest
rates implied by cash advances or payday loans.
That's a huge problem, as it means that far too many people are
in a situation where a minor fender bender could knock them out for
years. After all, if you need to borrow money to come up with the
cash for the repairs, then you'll not only be paying for the
repairs, but also interest on the borrowed money. The interest
could turn what would have been a minor incident into an expensive,
Back away from the ledge
Standard financial advice recommends an emergency fund with three
to six months of living expenses in it. That might seem like a pipe
dream to those with less than $1,000 to their names, but it is very
prudent advice, especially in a time of high unemployment. While
you should strive to get to that level, there's no law pushing you
to get there immediately.
In addition, it makes absolutely no sense to have a six-month
emergency fund earning just about 0% while simultaneously paying
20% or more in interest on credit card debts. As a result, any
emergency fund needs to be part of your overall cash management
get there, but you need to be smart about it. Here's a simple,
four-step plan to take you from debtor to investor, including that
well-stocked emergency fund:
Pay off any
. If you're paying more than 24% a year -- about 2% per month -- on
any debts, take any spare cash you come across and pay those off
before worrying about an emergency fund at all. This includes
payday loans as well as credit cards.
Seriously -- those payday lenders rake in some mighty fine cash
from those who can't get money any other way. Payday lender
) picked up more than $140 million in revenue last quarter. And
it's not alone.
) collected more than $132 million from consumer loan fees, and
' payday loan business raked in better than $28 million in revenue,
over the same period.
All three of those companies are profitable and pay dividends.
When all is said and done, which side of their operations would you
rather be on: The side paying the fees or the side collecting the
dividends generated by those fees?
Sock away that first $1,000
miniature emergency fund
. Yes, if you've got other debts, you'll likely be paying more in
interest on those debts than you'll be making on that $1,000, but
that can be OK. The point of that fund is twofold. First, it helps
you prove to yourself that you
save money, even if you've never been able to before. And second,
it's an insurance policy against having to take out even higher
cost debt because of a small, unexpected cost.
Pay off any other
debts and other
debts (like ordinary credit cards) as well. In essence, if it's not
keeping a roof over your head (mortgage) or enabling you to get a
higher paying job (school loan), it's probably not a debt worth
carrying. And even then, if the rates are much above what you can
earn on your savings, you might still want to pay off or refinance
those loans, as well.
While credit card costs aren't typically as high as payday
loans, they often carry double-digit interest charges along with
them. Partly, that's to assure healthy profits for the lenders, but
it's also partially due to the charge-offs of hopelessly delinquent
loans those lenders have to cover.
) had total charge-offs of more than $730 million in its last
Bank of America
) card services had $481 million provided for potential card
) , whose charge-card-centric model encourages prompt payment, has
been writing off about 3.4% of the amount charged on its cards.
That money has to be made up somewhere, and it largely comes from
pay their bills over time.
Save the rest of your emergency fund and
How to make it work
As simple as that four-step plan sounds, before you even get
started, you'll need to get in control of your overall spending.
Make a budget
that lets you prioritize what you really
, and cut back on everything else until you're able easily cover
today's costs of living on your salary, with money left over. Once
you set that budget, pay yourself first by putting every dime you
earn above and beyond that budget toward your four-step plan.
It takes discipline. It takes sacrifice. And it takes time. But
with all three, nearly anyone can become financially secure. That's
a much better place to be than living paycheck to paycheck with
less than $1,000 separating you from financial devastation.
At the time of publication, Fool contributor
owned shares of Discover Financial, Bank of America, and
American Express. The Fool owns shares of and has opened a short
position on Bank of America.
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